Life Insurance
In the last post, we discussed the different types of life insurance. In this post we will explore the benefits and disadvantages of life insurance in farm transition planning as well as strategies for using life insurance.
The Value of Life Insurance in Farm Estate Planning
Liquidity for Estate Taxes and Debts:
When a farm estate is passed on to the next generation, estate taxes and debts can create significant financial burdens. Life insurance provides the liquidity needed to cover these expenses, helping to prevent the forced sale of farm assets.
Equalization Among Heirs:
In many farm families, not all heirs are involved in daily farm operations. Life insurance can be used to compensate non-farming heirs, ensuring fairness while preserving the farm for those who continue the operation.
Succession Planning:
For farmers transferring ownership of the farm to the next generation, life insurance can be a crucial part of succession planning. It provides the financial resources to buy out other heirs or business partners, ensuring a smooth ownership transition.
Protection Against Loss:
In the event of the sudden death of a key family member, life insurance can provide the necessary funds to keep the farm operational during the transition period.
Disadvantages of Life Insurance in Farm Estate Planning
Cost of Premiums:
Life insurance, particularly permanent policies like whole or universal life, can be costly. The ongoing premium payments may strain the farming business, especially if cash flow is tight. Also, the premiums are not usually a deductible business expense.
Insurability:
Not everyone qualifies for life insurance. Individuals with pre-existing health conditions may be denied coverage. Additionally, as the applicant ages, premiums increase, potentially becoming unaffordable at some point.
Complexity of Policies:
Permanent life insurance policies, such as universal or variable life, can be complex and require careful management. Without proper oversight, these policies may lapse, resulting in the loss of coverage and forfeiture of premiums paid.
Limited Cash Flow Benefits:
While life insurance provides liquidity at death, it may not offer significant cash flow benefits during the policyholder's lifetime. Cash value accumulation can be slow, particularly in the early years.
Examples of Using Life Insurance in Farm Transition Planning
Off-Farm Heirs:
Andy and Betty own Family Farms. Their son Chris has returned to manage the farm, while their daughter Darla has pursued a successful career elsewhere and is not involved in the farming operation. Andy and Betty have a net worth of $3 million, but most of it is tied up in the farm, leaving little liquid cash. They purchase a second-to-die policy for $1 million and name Darla as the beneficiary. Upon their deaths, Darla will receive the $1 million death benefit as her inheritance, while Chris will inherit the farm, ensuring he can continue the operation without financial strain. This plan balances the needs of both heirs, providing liquidity to the off-farm heir while preserving the farm for the on-farm heir.
Debt:
Ed and Fran recently purchased a farm and owe $1 million on the property. They worry that if they die prematurely, the farm may struggle to meet the debt payments. To mitigate this risk, they purchase a second-to-die policy for $1 million. The death benefit will be used by their heirs to pay off the land debt, helping to secure the farm's future for the next generation. Any death benefit not needed to pay debt can go to their heirs.
Ownership Buyout
George and Harry are brothers who own and operate Family Farms LLC. They expect to continue farming for another 10 years. If either George or Harry die while they are farming, they want the surviving brother to be able to continue the farming operation by buying out the deceased brother’s ownership. The LLC is valued at $2 million. The brothers want $1 million to go to their family upon their death but do not want to burden the other brother with $1 million of debt.
George and Harry purchase $1 million, 10-year term policies for each other. If either brother dies in the next ten years, the surviving brother will receive $1 million death benefit which will be used to buy the deceased brother’s ownership. The $1 million in sale proceeds will go to the deceased brother’s family. The surviving brother will not need to worry about taking on debt to make the buyout. By using term policies, George and Harry were able to provide buyout funds while keeping the premiums costs significant lower than a whole life, universal or variable policy.
Effect on Estate Taxes
The death benefit of a policy is included in the estate of the policy owner. For example, if Ida owns a $1 million whole life policy which pays out to her beneficiaries upon her death, the $1 million death benefit will be included in her federal taxable estate. This presents a planning issue if life insurance is purchased to help pay estate taxes. Owning a life insurance policy will compound the estate tax liability of the estate.
A relatively easy solution to this issue is to use an Irrevocable Life Insurance Trust (ILIT). With this strategy, an ILIT is established that will purchase the life insurance policy. The grantor of the trust will pay the premiums on behalf of the ILIT and beneficiaries. Because the ILIT owns the policy and not the grantor, the death benefit is not included in the grantor’s estate.
Continuing the above example, Ida establishes an ILIT and the ILIT purchases a $1 million whole life policy. Ida pays the annual premiums on behalf of the ILIT. When Ida dies, the policy will pay $1 million to the ILIT. The ILIT will then distribute the $1 million to Ida’s heirs. The $1 million is not included in Ida’s taxable estate.
Conclusion
Life insurance can be a valuable tool in farm estate planning and transition or succession planning, offering liquidity, equalization among heirs, and protection against financial hardship. However, it is essential to carefully weigh the pros and cons of different policies and consider the long-term costs and management responsibilities. Life insurance is not needed for every transition plan. Farmers should consult financial advisors, estate planners, and insurance professionals to determine how life insurance may or may not fit their specific needs and goals. When structured properly, life insurance can help ensure the farm remains a viable operation for future generations while also providing financial security for heirs.
Farmers often face the challenge of being "land rich, cash poor." While they may have significant wealth tied up in land and other assets, they can lack sufficient cash to cover expenses, taxes, or distributions when planning for the farm’s transition to the next generation. This "land rich, cash poor" dilemma can complicate farm transition and succession planning, creating potential obstacles for a smooth handover of the farm.
Life insurance can provide a solution to this problem by introducing liquidity into an estate or trust, which can be used to cover expenses, taxes, and distributions to heirs. By incorporating life insurance into a farm transition plan, legal complexities and costs can be reduced, and the transition process can be streamlined. However, life insurance, like any estate planning tool, may be appropriate in some situations but not in others. This bulletin aims to explain different types of life insurance and how they can be used effectively in farm transition planning. Given the complexities of life insurance policies, it is essential to work with insurance and legal professionals to ensure that life insurance is appropriately included in your plan.
Types of Life Insurance Policies
Term Life Insurance:
Term life insurance provides coverage for a specific period (e.g., 10, 20, or 30 years). If the insured passes away during the term, the policy pays a death benefit to the beneficiaries.
- Pros: Lower premiums compared to permanent life insurance; simple and straightforward; ideal for temporary needs like covering a mortgage or debt.
- Cons: No cash value accumulation; coverage ends at the term’s expiration unless renewed, often at a higher premium; not ideal for long-term estate planning.
Whole Life Insurance:
Whole life insurance provides lifetime coverage with a guaranteed death benefit and includes a cash value component that grows over time. Typically, the premiums are fixed for the life of the policy.
- Pros: Permanent coverage with a guaranteed death benefit; cash value can be accessed through loans or withdrawals; fixed premiums for the life of the policy.
- Cons: Higher premiums compared to term life insurance; cash value grows slowly in the early years; limited flexibility in adjusting the death benefit or premiums.
Universal Life Insurance:
Universal life insurance offers permanent coverage with more flexibility than whole life. Policyholders can adjust premiums and death benefits within certain limits and earn interest on the cash value.
- Pros: Flexible premiums and death benefits; cash value accumulation with potential for higher returns; can be tailored to specific estate planning needs.
- Cons: More complex than whole life insurance; interest rates may fluctuate, affecting cash value growth; requires careful management to avoid policy lapse.
Variable Life Insurance:
Variable life insurance provides permanent coverage with investment options for the cash value. Policyholders can invest the cash value in various sub-accounts, such as stocks and bonds.
- Pros: Potential for higher returns through investment options; tax-deferred growth of the cash value; permanent coverage.
- Cons: Higher risk due to market exposure; policy performance depends on the chosen investments; requires active management and carries higher fees.
Difference Between Universal Life and Variable Life Insurance
Universal life and variable life insurance are both types of permanent life insurance, but they differ in flexibility, investment options, and risk. Universal life offers adjustable premiums and death benefits, with cash value growth based on an interest rate set by the insurer. This makes it a more predictable option with lower risk, though it offers moderate growth potential as the cash value isn't directly tied to market performance. Variable life, on the other hand, requires fixed premiums but allows policyholders to invest the cash value in various sub-accounts, offering the potential for higher returns. However, it introduces greater risk as the cash value fluctuates with the market, and there’s no guaranteed minimum cash value. Variable life policies are also more complex, requiring active management and often incurring higher fees. In summary, universal life provides predictability and flexibility, while variable life offers the potential for higher returns with greater risk and complexity.
Second-to-Die Life Insurance Policy
A second-to-die life insurance policy, also known as survivorship life insurance, covers two individuals, typically a married couple, and pays the death benefit only after both individuals have passed away.
- Pros: Second-to-die policies generally have lower premiums than two individual life insurance policies since the insurer pays out only after both insured individuals have died, reducing their risk exposure. Additionally, they are often easier to obtain for couples where one partner has health issues, as the payout depends on both individuals passing away.
- Cons: The death benefit is delayed until both individuals have passed, which may not provide financial assistance when the first spouse dies. This delay makes the policy less useful for covering immediate expenses or providing cash flow to the surviving spouse. Furthermore, second-to-die policies do not offer cash flow benefits during the policyholders' lifetimes, as the payout occurs only after death.
In the next post, we will discuss the advantages and disadvantages of life insurance as well as strategies to incorporate life insurance into a farm transition plan.
